Question

Explain the limitations of financial analysis.

Answer 1

The limitations of Financial Analysis are:

1. Ignores Changes in the Price level - The financial analysis fails to capture the change in price level. The figures of different years are taken on nominal values and not in real terms (i.e. not taking price change into considerations).
2. Misleading and Wrong Information - The financial analysis fails to reveal the accounting procedures and practices change. Consequently they may provide wrong and misleading information.
3. Interim and Final Picture - The financial analysis presents only the interim report and thereby provides incomplete information. They fail to provide the final and holistic picture.
4. Ignores Qualitative and Non-monetary Aspects - The financial analysis reveals only the monetary aspects. In other words, these analyses consider only information that can be expressed only in monetary terms. These analyses fail to disclose managerial efficiency, growth prospects, and other non-operational efficiencies of a business.
5. Accounting Concepts and Conventions - The financial analysis is based an accounting concepts and conventions. Therefore, the analysis and conclusions based on such analyses may not be reliable. For example, the analysis considers only the book-value of various items (i.e. according to the Going Concept) and consequently ignores the present market value of those items. Hence, the analysis may not be realistic.
6. Involves Personal Biasness - The financial analysis reflects the personal biases and personal value judgments of the accountants and clerks involved. There are different techniques used by different personnel for charging depreciation (original cost or written-down value method) and also for inventory valuation. The use of different techniques by different people reduces the effectiveness of the financial analysis.
7. Unsuitable for Comparisons - Due to the involvement of personal value judgment, personal biases and use of different techniques by different accountant, various types of comparisons such as inter-firm and intra-firm comparisons may not be possible and reliable.